Costco Wholesale Corporation (Ticker: COST) has seen a year-to-date return of 44%, not bad for 2019. But before you rush to buy the stock while trading at near-all-time highs, let’s take a deeper dive into the business itself.
Costco is the premier low-cost buyer and seller of products that the public has an ongoing need for, giving the business a durable competitive advantage. The company has 550 warehouses in the U.S. and an additional 235 international locations. I have personally been to a Costco warehouse in South Korea and they operate exactly the same as warehouses here in the U.S. They have done an outstanding job replicating the business model across markets. In August, Costco opened its first Shanghai location with 200,000 memberships in the first 5 months. A second location is in the works and the company plans to target China over the next several years.
Quite the run
Costco operates a membership model and it seems to be working. In 2019, the company had a 91% renewal rate domestically, and 88% internationally. Costco also has a private label, Kirkland, that is a powerhouse in the world of retail. Kirkland makes a variety of products that have proven popular over the years. In fact, Kirkland sales reached $39 billion in 2018 while Kraft Heinz only had $26.3 billion, demonstrating that its investment in the private label has paid handsome dividends. Speaking of dividends, the company has had 15 years of consecutive growth of dividend payments to investors, making the added cash flow just another selling point along with the appreciation of the stock.
Warren Buffett knows all too well about the appreciation of the share price over the past 19 years. In 2000, after a bleak earnings announcement, the share price fell 37%, making it a prime candidate for Berkshire’s portfolio. In the second quarter of 2000, Berkshire bought 24 million shares at approximately $30 per share. They don’t hold quite as many shares currently; however, since their initial investment, they’ve had a 931% return, compared to the S&P 500 return over the same period of 115%. Costco is trading at $295 today. So why not buy now then? Let’s keep analyzing the business.
Over the past 5 years, net income has gone from $2.3B to $3.6B with gross profit increasing more than $4 billion over the same timeframe. Costco reported Q1 fiscal 2020 earnings of $36.24 billion, up 5% year over year. The past 12 months yielded a 26% return on equity. Walmart, by comparison, has returned just 6%. Costco’s biggest competitor is Sam’s Club, which accounts for 11% of its parent company’s (Walmart) revenue. Walmart has Costco beat on gross profit margins, a figure arrived at by taking gross profit and dividing it by total revenue. Typically, a gross profit margin of 40% is a strong indication that the company is operating with a competitive advantage. Costco’s margin is 13% compared to Walmart’s 24%. Still, Costco is expanding aggressively into international markets, while Walmart has largely stayed domestic. Costco is also competing in the ecommerce and delivery spaces, offering same-day deliveries to customers within a 20-mile drive from any Costco warehouse.
Costco's gross profit margin of 13.0% is less than Walmart's 24.8%. However, both companies' net income margins are flat, with Costco at 2.4% against Walmart's 2.8%. Selling, general and administrative costs as a percentage of gross profit have hovered around 75% for the past five years, with companies such as Coca-Cola and Procter & Gamble routinely spending around 59% and 61%, respectively.
Walmart’s debt dwarfs Costco’s, making the investment somewhat safer if an economic downturn were to hit in the coming months. Servicing the debt of $77 billion is a much tougher task than servicing the debt of $7 billion. In 2019 alone, Walmart’s interest expense was $2.4B, compared to Costco’s $150M. Clearly, Costco is well positioned if the business sees decreases in revenue over the next couple years.
In closing, Costco serves a need that will most likely not go away anytime soon. People will still need (and want) to buy in bulk to create economies of scale for products and services that they see great value in. When you’re selling $5.3 million pumpkin pies annually, you must be doing something right. We see tremendous growth coming from the company in years to come, both with international expansion and ecommerce. As of just last year, Costco’s percentage of total net sales that comes from ecommerce was only 4%, so there’s a huge growth opportunity if the company can begin competing with Amazon on its delivery services; a formidable goal but one worth pursuing.